“We have always known that heedless self-interest was bad morals; we know now that it is bad economics.”

Archive for June, 2010

An interesting (if not insidious) argument in Todd Zywicki’s much-discussed* paper [PDF] on credit-card interchange fees is the claim that two-sidedness of the market — in a nutshell, it’s necessary have both buyers and sellers get on a payment platform as a prerequisite to carrying out transactions — upends the traditional efficiency appeal of pricing at cost:

The claim that interchange fees are too high is also problematic as a matter of economic theory, as it fails to appreciate the “two-sided market” of credit card networks in which overall network efficiency arises from the interdependencies of the network’s various actors and the ability to reallocate costs among them in order the maximize the value of the system as a whole on behalf of the beneficiaries of that system as a group.

There’s already one sleight-of-hand here, in that the theory suggests that cross-subsidies from one side of the market to the other may be efficient but not that platform owners’ economic profits are innocent. Moreover, two-sided markets theory doesn’t specify which side(s) of the market get the subsidy as a general matter, so you can’t simply say “two-sided markets hence this subsidy.” I’m not suggesting that readers not believe in potential network externalities, just warning that there’s considerable risk of just-so storytelling.

To that end, I suggest a thought experiment. Imagine a world where the price on the supposedly subsidizing side were lower than it is now, and the subsidized side were higher, and the state of the market that implies. There’s a two-sided markets argument to make for additional subsidy if you would look at the resulting market conditions and say, “Wow, we really should impose a tax to bring up the subsidizing price to today’s level and provide today’s subsidies to overcome obvious network externalities!”

In the case of credit-card interchange fees, this state of the world isn’t terribly hard to imagine. Set the way-back machine to the early- to mid-1990s, and there are lower interchange fees, few rewards cards, and fairly high rates of adoption of credit cards. (The dominant forms of rewards cards at the time are oil company loyalty cards, which as Adam Levitin observes are a conceptually different form of “subsidy,” and airline frequent-flyer affinity cards charging cardholders above-average annual fees.) It’s 1991. Should we impose a tax of a quarter or a half-percent on (at least) a portion of merchants’ receipts to give out cash or frequent-flyer miles to subsidize further credit-card spending?

My guess is that if I walked into a GMU law and economics seminar in 1995 and proposed a sales tax to give perks to the credit-card constrained** to overcome network externalities in payment markets that I’d have been laughed back to College Park. But then I’m just cynical.

Kevin Drum suggests (modestly or “modestly”) that “everyone” should love the idea of trading the corporate income tax for carbon and financial transactions taxes. I should just have a chuckle and leave it at that, but then again I get emails from the Tax Foundation that are remarkably lacking in irony. Ezra Klein is happy with his policy-wonk hat on, but thinks there’s a political problem of giving fat cats an obvious break. I argue that the problem is not just political. Drum’s at least semi-serious claim is that taxing corporate income is bad because doing so is a drag on business and ends up getting paid by individuals anyway. Neither necessarily militates against corporate income taxation in the real world.

Whether a “drag” on business or some other tax distortion that reduces private-sector activity (other things equal) is good or bad, on net, depends on the use to which the tax revenues are put. In a world such as ours where public expenditures serve as public capital and intermediate goods in addition to government consumption, it’s straightforward to write a model where distortionary taxes are optimally set at non-zero levels. (I once assisted the late Mancur Olson in doing so.) These models do not even have to appeal to left-leaning aspects of reality such as the economic efficiency of negative-sum redistribution when marginal utility is declining and income and wealth are (very) unequally distributed. So even if Drum’s switch is revenue-neutral and doesn’t stiff the government as such, it may still be improved upon — maybe not from the Tax Foundation’s perspective — by adding the distortionary tax on top of the efficiency-improving Pigovian taxes and spending the proceeds wisely. Moreover, while we’re in tax policy fantasyland, the corporate income tax could be made more efficient without necessarily reducing its revenues by way of reforms that broaden its base and reduce the statutory marginal rates.

Second, merely noting the ultimate incidence of the corporate tax on individuals fails to consider significant issues of which individuals end up paying the tax. Certainly, the tax may be passed onto individuals in part in their role as customers of businesses subject to the tax, but it will also fall on individuals as shareholders in the businesses to the extent the tax can’t be passed through. Since shareholdings remain highly concentrated among the rich, this creates equity issues center-left wonks like Drum and Klein should be happy to entertain.

Moreover, eliminating taxation on corporate income would tend to have knock-on effects making the individual income tax system less efficient. When tax system complexities create categories of income with preferential tax treatment, it creates opportunities for people who can choose how to realize their income to take their income in the low-taxed form. This narrows the tax base and requires higher (and less efficient) rates to produce a given level of revenue. In this case, untaxed corporate income gives retained earnings an indefinite tax deferral, so the incentive is to convert income from shareholdings such as dividends into unrealized capital gains (which also are tax-deferred).

The argument remains that making fat cats fatter is a small price to save for saving the planet for everybody else. I can almost swallow that, but note that much of the noise over reforms seem to be geared towards masking the fact that people with ownership in existing corporations have as much or more to lose from climate and financial catastrophes than the rest of us suckers.